The Reserve Bank hasn't ruled out the possibility of negative interest rates, a new territory for monetary policy in NZ. Paying borrowers and charging lenders seems to go against common sense. But in Japan and parts of Europe, short-term rates have been negative for quite some time.
This is alarming for some; we fielded many questions on this topic back in 2016. But a good investment strategy is robust in all environments and we believe negative rates alone shouldn't necessitate changes.
It is very unlikely negative rates would be passed on to bank's retail clients, but let's look at the implications if this were the case.
Good plans work in all situations
There are common themes to all plans we work on with clients; the plans all include:
An emergency fund in cash for unexpected expenses and peace of mind
Cash or term-deposits put aside for short-term spending
A mix of well-diversified shares and bonds, providing a balance between returns and stability for goals and comfort levels.
This makes sense in all interest rate environments. Having cash there when you need it is more important than returns, even if you have to pay for the privilege. If you have more cash than you need, it should be invested for your long-term goals.
For example, Rob Stock of Stuff mentions why he kept cash aside while paying his mortgage, even though he was paying more interest:
“Having some money in cash, for example, while at the same time having a mortgage always seemed economically irrational as banks lend money at higher rates than they pay to borrow it from depositors.
But many people keep a cash buffer, even when they have a home loan. I always did when I had a home loan.
I was willing to pay that cost, as I was willing to invest in KiwiSaver and keep some direct shareholdings, because I wanted to be able to meet all my obligations without having to go cap in hand to the bank for more debt, if I ever had a period of unemployment.”
We mentioned in a previous article how to best set-up your different accounts and how much to have in each. In summary:
Spending accounts - Keep enough for regular spending and purchases for the next month or so.
Savings accounts - You should have an emergency fund in savings, typically 3 - 6 months spending. Also appropriate for goals coming up in around 3 - 6 months.
Term deposits - Useful for goals in the next 3 - 18 months, if you are reasonably certain when the money is needed.
Shares and bonds - Further than a year into the future, investing in bonds will likely earn you more than term deposits. For your mid-term/long-term goals, get advice on what portfolio is right for your needs.
Notice we never mention returns directly, as the more important factor is risk.
Whether the OCR is set at 0% or 5%, we expect you will earn a little bit more in a savings account, more again in term deposits and even more in bonds or shares. And each step away from cash moves further up the risk ladder.
If you have goals coming up this year, shares are too risky for these funds. For goals still decades away, sitting in cash is a wasted opportunity, and the less risky option means falling short of these goals. This remains true no matter what is happening with interest rates.
Why not keep cold, hard cash?
If you had to pay to have money in the bank, why not keep physical currency?
How much is the convenience of electronic banking worth? Or the safety of not carrying wads of cash in our wallet or in our homes?
You could rent a deposit box for around $20 per month and keep your cash there. Unless you had more than $40,000, with an interest rate of -0.5%, you would be paying more for the box, with the added inconvenience of a physical location to visit.
Another option is purchasing a safe at home, if you think you'd get your money's worth. There is still the added pain of having to pay in cash all the time.
So you could avoid paying interest by withdrawing your cash. We believe the convenience and safety of the bank is worth paying a little interest.
What does it mean for my shares?
In general, rates cuts are considered good for shares and hikes bad. Of course, the main purpose of monetary policy is to change the incentives for consumers to spend and businesses to borrow, controlling inflation and growth. Rate cuts promote spending and cheapen business debt, so we expect business earnings to increase.
This does not apply to all businesses. Banks will feel a negative impact as their interest earnings decrease. Importers may see costs increase if rate cuts weaken the NZD.
Discussing these trends and capitalising on them are two very different things, as markets are constantly factoring in expectations and new information. If a rate change was 100% known beforehand, prices would not change. If it were unexpected, prices would adjust rapidly, offering no chance to benefit from the change after it has happened.
Negative rates are concerning in that their implementation show the great lengths necessary to create growth in the economy. This does not mean a poor investment climate. Japan implemented their negative rate policy way back in January 2016. Over the next four years, their share market index (Nikkei 225) gained more than 7% p.a. excluding dividends.
What does it mean for my bonds?
The return on a bond is tied to interest rates, so with negative rates, newly issued bonds will be less appealing. Short-term, we will likely see prices rise, as bonds that were issued prior now pay more interest than newly issued ones.
This also depends on the expectations of investors. Prices may increase before the change in interest rates if investors see the change coming. Bond markets are very efficient, with strong price movements following unexpected events, not expected ones.
For example, in 2019 we saw a sharp increase in bond prices when the Federal Reserve cut rates in the US. At the time, the commonly held belief was rates couldn't go lower.
Like with shares, the effects are complex. We often see longer-term bonds increase in value while short-term bonds decrease and vice versa. After all, rates cuts are meant to stimulate growth, which may reduce the risk that companies cannot make bond payments.
So for the bonds you already own, the effects will likely be positive short-term. But would it make sense to continue to invest in bonds?
As part of a diversified portfolio, bonds offer stability, offsetting the volatility of shares. This stability remains in a negative rate environment, so no changes are needed in response to rate cuts.
What type of bonds you invest in shouldn't change either, as the decision regarding which to include is based on risk, the stability needed for your situation.
The danger of chasing higher yields
It may be tempting to move up the risk ladder as the returns on bonds is lower. Be very careful, as you don't want to exceed your risk tolerance.
The thing about these risks is you can't control how much you are compensated for accepting them. You essentially get what you are given. If the reward is lower than we would like, it is tempting to seek out more lucrative investments. But risk=reward, and this search for yield leads to risks not aligning with your goals.
Interest rates have been low for quite some time. I find it concerning when I read articles about "the search for yield", like this one from last year by CNN. They suggest two commonly touted strategies to get a bit more from your investments.
First they suggest dividend paying stocks, which is a huge step up the risk ladder from cash or bonds. The risks of owning part of a company are too often dismissed in these articles. Usually this is because the chances of something affecting dividend payments is seen as incredibly unlikely. For this reason, airport stocks were often favoured for steady dividends.
For the first three dividend-paying companies mentioned in that article, here is what happened to their share prices during the February-March downturn:
For a long-term investor, with a well diversified portfolio and a high risk tolerance, this is not the end of the world.
If you had invested in these companies to earn a steady income higher than bonds or cash, this is a terrible outcome. While investment-grade bonds are very unlikely to stop interest payments, it is possible these companies will suffer further or stop dividends altogether.
This dividend-chasing problem has hit some Australian retirees particularly hard, as Peter Mancell, a successful adviser from Tasmania, discusses in this scathing article.
Another alternative suggested is high-yield bonds, better described by their other name, junk bonds.
Junk bonds pay more interest because the companies who issue them are more likely to not make repayments. The probability of being paid in full and on time for investment-grade bonds is higher than 95%. For junk bonds the chance is at best 90%, and much lower for the worst-rated.
Cross the line from investment-grade to junk and the defensive part of your portfolio starts to look more and more like a risky growth investment. The CNN article provided two benchmarks for high-yield bonds. Both approached -25% returns over February/March, similar to the returns of share markets.
Even some local investment managers were hit hard by this, as funds described as "income funds" generated some of their returns from junk bonds.
What should we do with negative rates?
So negative rates aren't the end of the world for shares or bonds. If your cash and investments are already aligned with your goals, it is unlikely you will need to change anything.
If you are concerned that lower returns on cash and bonds may affect your ability to reach your long-term goals, we can discuss changes to your portfolio. However, the only way to achieve higher returns is to accept more risk, which means investing more in shares and less in bonds.
The caveat is, during periods like the first quarter of this year, your investments may fall in value quite rapidly. For experienced, long-term investors, this is acceptable. If you are less experienced, withdrawing from your portfolio, or expect to do so in the near future, this risk may be unacceptable.
Negative interest rates may be the catalyst needed to review your financial plan. A better time to review your plan is always right now.